The ABCs of MLPs
If you’re looking for steady, reliable income, midstream master limited partnerships (MLPs) are a great place to start.
So says Investing Daily analyst Robert Rapier, one of the pros behind our Energy Strategist and MLP Profits advisories.
“I am a relatively conservative investor,” writes Rapier in the latest Energy Strategist. “I expect that I still have a number of years until retirement, but the closer that time comes, the more conservative I become. When I do retire, I, like many other investors, will mainly use my investments to provide a steady and fairly reliable income stream. This is where midstream MLPs excel.”
“Midstream” simply means these partnerships run the decidedly unsexy operations—think pipelines and storage tanks—that are nonetheless vital for getting oil and gas from field to market. (Not to be confused with upstream MLPs, which focus on production, or downstream partnerships, which refine and distribute fuel.)
A Leg Up on Oil Prices
A good way to think of midstream MLPs is as toll collectors, collecting a fee for every barrel of oil or cubic foot of natural gas that passes through the network.
But they also enjoy an added benefit: their contracts typically lock in a big chunk of that income—even if a customer doesn’t ship a drop. That means they’re more insulated from whipsawing oil prices, like the ones we’ve seen lately, than their upstream or downstream cousins.
Still, you shouldn’t take that to mean they can’t lose value, writes Rapier:
“One component of an MLP’s value rests on the expectation that it will be able to grow distributions [as dividends are known in the MLP world] by adding new infrastructure. If oil and natural gas prices remain depressed, the infrastructure build-out will slow, dampening distribution growth.
“Thus, the prices of midstream MLP units have dropped along with the price of oil—but their decline has been relatively mild in comparison with drillers’ shares.”
The numbers bear that out.
Since it began its slide in late June, the price of oil has dropped around 52%. In that time, the Energy Select SPDR ETF (NYSE: XLE), which mainly consists of major oil and gas producers and oilfield service firms, has shed about 20% of its value.
Meanwhile, the Alerian MLP Infrastructure Index ETF (NYSE: AMLP)—made up, as the name suggests, mainly of midstream partnerships—is down about 7%.
But it’s as long term-holdings that midstream MLPs shine: as Rapier demonstrates in his article, since inception in 1995, the Alerian ETF’s underlying index, the Alerian MLP Infrastructure Index, has risen at a steady pace, with few significant corrections, while yielding an average of 7.5%.
Below is a brief history of MLPs and a bird’s-eye view of how they benefit investors. Further on, we’ll examine one midstream partnership we recommend in MLP Profits.
A Brief History of the (MLP) Universe
MLPs trade on the major exchanges, just like stocks, and can be bought or sold through any broker. They raise capital by issuing units—the equivalent of shares of common stock. When you buy an MLP, you’re known as an LP unitholder.
But here’s a key difference: MLPs don’t pay tax at the corporate level. Instead, they pass through most of their income to investors in the form of regular distributions, which investors then pay individual tax on.
That frees MLPs from the double taxation most corporations have to deal with (i.e., corporate tax at the corporation level and income tax at the shareholder level).
The result? MLPs can provide limited partners—investors—with more cash.
But there’s more.
Thanks to high depreciation and amortization charges, up to 90% of the cash distribution you get from an MLP is treated as a return of capital, which is not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.
The rest of the distribution—typically 10% to 20%—is taxed as ordinary income. But being able to defer the rest of the tax until the investment is sold is an advantage, because you can reinvest that income to generate compound returns that could more than pay for the eventual tax bill.
Of course, there are some potential drawbacks with MLPs. One is that they can make your taxes more complicated.
MLPs issue Schedule K-1 forms instead of the 1099 forms you may get from a corporation, and the K-1 package will include a state schedule that details the MLP’s share of income or loss attributed to each state in which it operates (a pipeline, for example, may span five states). You may have to file state tax returns for each one—though most individual investors fall well under the threshold for having to do so.
Apache Oil Company formed the first MLP in 1981. Other oil and gas and real estate firms followed, but the structure soon spread, drawing in everything from restaurants to casinos, hotels and cable companies.
Little-remembered fact: even the NBA’s Boston Celtics once operated as an MLP.
As you might expect, none of this escaped Congress’s notice. Worried about lost tax revenue, it legislated new rules in 1987 stating that at least 90% of an MLP’s income must come from qualified sources, such as natural resources or real estate.
Few businesses—inside or outside the MLP universe—can boast the kind of reach MLP Profits recommendation Enterprise Products Partners (NYSE: EPD) has; it’s the largest publicly traded MLP in the US.
Enterprise operates 51,000 miles of pipelines, six offshore production platforms, 24 natural gas processing plants and numerous storage facilities. It also has a marine services business with 55 towboats and 176 barges, as well as natural gas liquids import/export facilities at the Houston Ship Channel.
The units have posted a total return of 277% since MLP Profits first recommended them in May 2009. In early January, Enterprise raised its quarterly distribution by 5.7%, to $0.37 from $0.35, for a 4.2% yield. The move marked the MLP’s 42nd consecutive quarterly hike.
Late last year, Enterprise announced that it would extend its reach further through a $6-billion deal for Oiltanking Partners LP (NYSE: OILT). Among other assets, Oiltanking owns a terminal in the Houston Ship Channel that’s connected to Enterprise’s liquefied petroleum gas (propane or butane), octane-enhancement and propylene complex in Mount Belvieu, Texas.
Investing Daily analyst Igor Greenwald sees the acquisition as just one of Enterprise’s strengths, despite low oil:
“[Enterprise’s] long-term service contracts provide protection … and a pool of retained and reinvested earnings secures the distribution,” he wrote in the latest MLP Profits. “The Oiltanking buyout ensures the partnership will remain a key player in Gulf energy exports.”
Beat 95% of the Market With MLPs
With their fat distributions and steady price gains, MLPs have made mincemeat out of stocks, returning 15.2% a year for 10 years running. That’s better than 95% of US stocks!
What’s more, some let you pocket high yields for 10 years or more before you pay a single penny of tax. One of our favorites yields 11%, and you can defer taxes on 95% of your income—in some cases forever.
Get the full story here.